Uncertainty may dog institutional investors in 2014

Fed tapering, asset allocation decisions make execs nervous

Scott Malpass is not happy over the prospects for further government intervention.

Uncertainties about what to do in rebalancing and the uncharted waters of central bank accommodation are among the things that'll bring sleepless nights to investment executives and money managers in the coming year.

“The scary thing is the thing you don't expect,” said James Keohane, president and CEO of the C$47.4 billion (US$44.6 billion) Healthcare of Ontario Pension Plan, Toronto. “It's hard to know what there is in store.”

“Everything keeps me up at night,” said David Cooper, chief investment officer of the $28.3 billion Indiana Public Retirement System, Indianapolis.

“Asset allocations are probably out of whack right now,” generally overweight stocks and underweight fixed income, added Tim Barron, CIO at investment consultant Segal Rogerscasey in Darien, Conn. But given the 2013 jump in stock prices and the ongoing concern over core fixed income, he added, “how do you feel about selling stock and buying fixed income? That's a stRogerscasey in Darien, Conn. But given the 2013 jump in stock prices and the ongoing concern over core fixed income, he added, “how do you feel about selling stock and buying fixed income? That's a struggle.”

What's expected is the continued tapering of the Federal Reserve's quantitative easing strategy, and that equities will continue to see growth, but not at a breakneck pace. The Fed started the tapering ball rolling on Dec. 18 by announcing that beginning in January it will buy $75 billion in bonds each month, down from the $85 billion it has bought since September 2012. It also pledged to keep short-term interest rates “exceptionally low,” according to a Fed statement Dec. 18.

The Fed effect will be a short-term one,” said Anthony Werley, New York-based managing director and chief portfolio strategist in J.P. Morgan Asset Management's endowments and foundations group. “The short-term volatility from whatever easing up the Fed does will cause concern.”

In alternatives, value-added and opportunistic real estate is “something to get quite excited about” in the new year, said Mr. Werley. “To me, a high value-added/opportunistic portfolio is like (2013's) small caps,” he said. “There are some real opportunities in higher-risk real estate.”

But hovering over 2014, Mr. Werley added, is the issue of what inflation numbers will be. “You can't completely take your eyes off deflation. If you don't get the economy to accelerate, what is the "new normal' will become the "old normal,' with price/earnings ratios not justified.”Mr. Barron agreed real estate provides some attractive opportunities for income and protection from inflation and a breakdown in equities, along with timber, agriculture and infrastructure. He also said hedge funds will continue to get inflows despite the tepid returns of the past year, since many institutions' commitments to the asset class remain unfulfilled.

Accomodation a concern

The Fed's accommodation, as well as similar actions by the European Central Bank and the Bank of Japan, are an “overriding concern” to Scott Malpass, vice president and chief investment officer at the University of Notre Dame, South Bend, Ind. He oversees the university's $8.7 billion endowment. “Even though we're bottom-up investors, we're very aware of the macro environment,” Mr. Malpass said. “The force of the Fed accommodation, also at the ECB and Bank of Japan, we haven't see this since the 1940s. It's a force that's powerful and could surprise people.”

“You'd be crazy not to be concerned about the effects of accommodation,” said Mr. Barron. “Where we are now on central banks' balance sheets is unprecedented territory. To be concerned how that plays out over the long term, we would certainly agree.”

Mr. Werley said tapering is utmost on the minds of institutional CIOs. “Overwhelmingly, the question they're asking is, "What do I do with my fixed-income portfolio?'” he said. “Whether it's for liquidity, deflation protection or volatility reduction, let's find something more to do with fixed income.”

The Fed's actions in 2014 will have a direct effect on investing in fixed income and equities — and, according to Mr. Cooper, its future actions may already have had an effect. “My concern is, I don't see any asset class that's extremely undervalued,” he said. “I'm concerned that with the Fed's quantitative easing, how much have returns been brought forward to now so that the risk premium has shrunk. For most people, it depends on the Fed's balancing act. Can they step off the gas without hurting the economy?”

HOOPP's Mr. Keohane agreed. “I don't see rates having a high upside,” he said. “By the time the Fed takes its foot off the accelerator, it's already been taken into account in the market.” Mr. Keohane said HOOPP focuses on short-term valuations, and thus when investor sentiment is very high — as he said it is now — “it's a reverse indicator, a red flag for us.”

Mr. Barron said the Fed's attitude of “don't worry, be happy,” since it doesn't plan on raising interest rates until 2015 or later, will make credit and high-yield fixed-income strategies more attractive for investors that need to rebalance into fixed income.

Big equity questions

In equities, Mr. Keohane said overvaluation could be a problem, with the S&P 500 about 7% overvalued. “In the past, when we have seen the S&P 500 reach these levels of overvaluation, it means that the market is discounting a lot of good news, so if that good news does not materialize we can experience significant market corrections.”

If tapering doesn't harm the economy, added Mr. Cooper of INPRS, equities should primarily benefit, though he's cautious as to how much. “We're always concerned about the left tail,” he said.

For equities, this year will see institutional investors take on more risk, said Robert Doll, chief equity strategist and senior portfolio manager at Nuveen Asset Management, Chicago. “The U.S. economy will be a bit better but more importantly, a bit broader,” he said. “That broadening will enable investors to take on more risk. Risk will outperform, not as significantly as 2013, probably smaller. If I'm a pension fund manager, recognizing the long-term aspect of my investments, I have to take a little risk to get returns.”

Added Mr. Werley: “People are asking to take on more risk. 2013 has provided this screen that makes people forget what happened in 2008. That's a classic reaction. Everyone wants to make that change, cut the downside risk and take advantage of the upside.”

The big equity question going into 2014 is “what now, small caps, and what now, emerging markets?” said Mr. Werley.

He said emerging markets should rebound from the doldrums of 2013 to deliver “high single digits to 10% returns in a well-selected portfolio. I don't think small caps' days are over, but you'll see more of a pause (in growth), with fairly mediocre results” compared to the 40% rise in the S&P 600 small-cap index in 2013.

Mr. Doll said fixed-income rates shouldn't go up very high if the economy — “not just here, but globally” — continues to improve, although he would be “cautious about duration.” And although the global economy will need to strengthen, the U.S. “is still at the core if we're going to increase growth,” Mr. Doll said.

He said Japan is undergoing a “creative experiment” with its central bank's policies that should help see overall economic growth in Japan continue, which should sustain the rise in Japanese equities seen last year, he added that emerging markets, which had sagged in 2013, should stabilize.

“It's hard to find areas of the world with much greater growth than they had” in 2013, he said. “There's a healthy amount” of economic growth around the world.